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US investors cheered

Bob Doll, global chief investment officer for Black Rock, provides his weekly investment commentary from New York

Last week’s market news was dominated by the results of the bank stress tests and by Friday’s release of the April employment report. In both cases, investors were cheered by the news and bid stock prices higher yet again. For the week, the Dow Jones Industrial Average advanced 4.4% to close at 8,575, the S&P 500 Index rose 5.9% to 929 and the Nasdaq Composite climbed 1.2% to 1,739. Since the rally began on March 6, stocks have climbed almost 40%, which, for the year, has pushed the S&P into positive territory, the Nasdaq to over 10% and the Dow almost back to positive.

The results of the bank stress tests showed that the federal government believes that 10 of the 19 banks examined have capital shortfalls and will be required to raise a total of $75 billion in additional capital. This is a relatively modest amount compared to expectations of several weeks and months ago, and the government is hopeful that the news will restore some confidence among investors and the public. From our perspective, we are somewhat sceptical about the results and believe that the downside risks for many banks remain a concern. This is particularly true considering that, only two months ago, many were concerned that conditions were so dire that some of these banks might need to be nationalised.

On the employment front, April’s data showed that the economy shed 539,000 jobs, which pushed the unemployment rate to 8.9%. These results were somewhat better than expected, which reinforced the perception that the pace of the recession is slowing.

The “V-shaped” rally in stocks over the past couple of months has caused some to wonder whether we will also see a V-shaped turnaround in the economy. In our view, such hopes are probably overly optimistic. The economy remains in fragile shape, and we are also growing more concerned about the size of the federal budget deficit. The deficit could approach $2 trillion this fiscal year, which would represent 13% of overall US gross domestic product. Given the volume of current spending and potential new government initiatives still on the table, spending levels are likely to remain high over the next several years, a fact reflected in the significantly higher Treasury yields that have emerged over the past couple of weeks.

On balance, the general sentiment has changed over the past couple of months. Investors, not long ago worried about a global economic meltdown, have now started to look for preliminary signs of economic improvement. Certainly, it does seem clear that credit markets have improved and some signs of economic stabilisation have emerged. Central banks and other policymakers around the world have also helped create an equity-friendly environment through widespread monetary and fiscal stimulus, which has helped produce ample liquidity. At some point, equity markets will require the economic backdrop to actually improve rather than simply grow less bad, but on balance, we believe policy reflation is working, and this should help establish a floor for equity prices.